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Trusting Capacity Markets

Does the lack of long-term pricing undermine the financing of new power plants?

Fortnightly Magazine - December 2011

with high levels of debt ( e.g., 70 to 80 percent debt) can reduce the levelized annual investment cost of a project by 10 percent to 20 percent compared to merchant plant financing, which may allow financing with only 30 percent to 50 percent non-recourse debt (backed solely by the project) or 50 percent to 60 percent corporate debt (backed by the entire parent company).

A range of financing arrangements will exist in well-functioning markets. Buyers can assume risks under a long-term contract—which supports more highly leveraged financing by the developers—or developers can assume these risks—which requires financing with more equity—depending on risk sharing preferences and the financial conditions of the counterparties.

Until new generation is actually needed, it isn’t desirable to enable uneconomic investments in new generation through long-term power purchase agreements (PPAs) when those developments are more costly or more risky than capacity from market-based resources, including from existing generation supplies and demand response when new generation isn’t needed.

Reforming Default Service

Longer-term contracting should be expected to increase as capacity market prices reach and sometimes exceed the cost of new generation. It’s conceivable, however, that market or regulatory barriers could prevent an outcome in which an efficient level of longer-term contracting can be achieved.

The current nature of retail services in restructured states may represent such a barrier that might inhibit reaching optimal levels of long-term capacity contracting. That is because a significant portion of retail load is supplied under regulated default service arranged by electric distribution companies and overseen by utility commissions. In restructured eastern PJM states, such as New Jersey and Maryland, the distribution companies are required to procure bundled energy and capacity supplies for these default service obligations. The contracts for such default service procurement have durations of only three years or less. This sole reliance on short- or intermediate-term contracts under state-regulated default service procurement appears to deviate significantly from the procurement and risk management practices of large competitive retail service providers.

Many competitive retail service providers secure a meaningful portion of their supplies through long-term contracts or even the acquisition of generating assets. Such actions are designed to counter the effects of perceived broken linkages between competitive retail and wholesale markets by reducing the transaction costs of securing long-term contracts and effectively vertically re-integrating load-serving responsibilities with merchant generation. For example, Constellation’s NewEnergy retail supply business obtains energy from a portfolio of various sources, including its own generation assets, contractually-controlled generation assets, exchange-traded bilateral power purchase agreements, unit-contingent power purchases from generation companies, tolling contracts with generation companies, and spot purchases from the regional power markets. 5 This portfolio balances retail sales contracts that are reported to extend from one to 10 years and beyond, although these generally won’t be exactly matched by long-term capacity procurement contracts. Constellation Energy explicitly stated that its that its strategic objective for retail service operations is to buy generation assets in regions where the company doesn’t have a significant generation presence and to enter into longer-term agreements with merchant generators. In fact, this objective was a primary